Most favoured nation principle: a problem for UK’s financial services?

Last month Chancellor Philip Hammond suggested that it is in the ‘mutual interest’ of both the United Kingdom and the European Union to include financial services in the future EU-UK trade deal. Whether the interest is ‘mutual’ is subject to debate, but the benefits of an open market in financial services sector from the UK’s perspective are undeniable. According to some estimates, approximately half of UK’s revenues from financial services are from international business and the EU is the world’s largest importer of services.

In reply to Mr Hammond, the EU’s chief Brexit negotiator Michel Barnier noted that a free trade agreement (FTA) that includes financial services simply does not exist. In line with Mr Barnier’s scepticism, the European Council guidelines of 23 March 2018 on the future EU-UK deal (henceforth the ‘Guidelines’) say little about financial services. The Guidelines note that market access for trade in services will be open ‘to an extent consistent with the fact that the UK will become a third country’. Similarly, the European Parliament, in its 5 March Resolution on the future of EU-UK deal, (henceforth the ‘Resolution’) noted that under an FTA market access for services is limited (for more on these EU policy documents, see Explainer here).

It seems that the EU is not rushing to provide full access to the UK’s financial services sector. But even if convinced otherwise, is the EU free to do so?

Market access for financial services – what does the UK need?

Let us start from what is in the UK’s interest in the post-Brexit financial services deal. As a member of the EU and the European Economic Area (EEA, for more on EEA, see Explainer here), the UK has been enjoying so-called ‘passporting rights’. These rights allow banks and financial companies authorized in one EEA state to provide services to clients in other EEA states without a local authorization. They can do so either by establishing a branch in one of the EEA members (i.e. all EU member states and Iceland, Liechtenstein and Norway) or providing services across borders. Firms based in countries outside the EEA do not enjoy such unrestricted access to the EU-wide market.

The UK has so far rejected becoming a member of the EEA in its own right (ie not as a Member State of the EU). Such membership provides access to the single market, but would involve free movement of persons. The UK could, upon leaving the EEA, seek to join some ‘third country regimes’ under which the EU provides limited market access to non-EU firms – but those rights do not amount to passporting rights.

Losing passporting rights would have an impact on the ability of financial firms based in the UK to offer their products and services to EU clients. Accordingly, financial institutions are re-thinking their location policies, which may threaten London’s position as a global financial hub. If membership of the EEA is impossible, given the UK government’s red lines, the UK will have to negotiate access to EU’s financial markets through a trade agreement.

So what could the UK get from a standard EU free trade agreement (FTA) for its financial services? Let us look at the EU-Canada Comprehensive Economic and Trade Agreement (CETA) to see the level of market access that the EU has negotiated with Canada.

Financial services under CETA

Financial services are governed by Chapter 13 of CETA. CETA follows closely the WTO regime for services. It allows service providers to conduct cross-border activities via the GATS-model four modes of supply: (i) cross border trade (e.g. a Canadian consumer purchases securities from a financial institution located in Italy) (ii) consumption abroad (e.g. a German consumer purchases financial services while travelling in Canada) (iii) commercial presence (e.g. a Canadian bank sets up operations in Spain) (iv) services supplied through presence, and in some cases employment, of natural persons (e.g. a Spanish citizen supplies financial services in Canada or a Spanish firm provides financial services in Canada and sends its Spanish staff to provide those services).

CETA does not establish the degree of market access enjoyed within the EU single market. While it allows temporary entry and stay of natural persons for business reasons, it does not contain passporting rights. A local licence is thus required in order to provide financial services. A Canadian financial service provider wishing to do business in the EU, and vice versa, has to meet local regulations. CETA does not require the EU and Canada to align its laws (i.e. make them similar) which makes passport-like mutual access unlikely.

It is thus doubtful whether the UK would be satisfied with a Canada-style deal. It will likely seek a ‘Canada plus plus plus’ agreement in financial services which would offer more than CETA, such as passporting rights. The following question is thus whether the EU can offer UK a ‘Canada plus plus plus’ deal without violating the rights of its other trading partners. The answer lies in the scope of a most-favoured-nation (MFN) clause.

What is a most-favoured nation clause?

To put it simply, an MFN clause is a non-discrimination requirement. It means that if you give a favour to one trading partner, you have to give it to all partners who benefit from an MFN clause. The principle is central to the World Trade Organization (WTO) which requires a member to give equal access to its home market to all members of the WTO. An MFN clause applies both to trade in goods and services.

What matters for present purposes, however, is not an MFN clause under the WTO Agreements but an MFN clause under the EU’s trade agreements with non-EU countries. The EU’s FTAs also contain an MFN clause which means that the EU must provide equal treatment to those trading partners who benefit from an MFN clause under their FTAs with the EU. What the EU offers to the UK must, then, be offered to Canada, Korea, Singapore and other partners with whom the EU has negotiated an MFN clause.

There are, however, important exceptions to an MFN clause under these new FTAs. Under CETA, an MFN obligation does not apply to cross-border trade in services (Article 9.5(3)) and investment which covers provision of services through commercial presence (Article 8.7(3)) if a measure provides for, among other things, ‘recognition’ (i.e. acceptance of each other’s standards, such as professional qualifications, as sufficient). Passporting rights may be covered by this exception because they allow free access to financial services market without imposing further regulatory requirements (i.e. local authorizations), thus constituting recognition of UK home state regulations. The relevant provisions of other FTAs differ from the CETA text to some degree. For example, the EU-Korea FTA provides an exception to an MFN clause, among other things, in the case of measures providing for a recognition of licences. Such an exception is also likely to cover passporting rights.

Furthermore, Annex II of CETA establishes additional reservations (i.e. exceptions) applicable in the EU. One of the listed reservations to an MFN obligation in trade in services provides that the EU reserves the right to adopt an agreement with a third country (i.e. UK in case of an EU-UK deal) which (a) creates an internal market in services and investment; (b) grants rights of establishment; or (c) requires the approximation of legislation in one or more economic sectors (i.e. alignment or incorporation of laws between the parties). While the first two options seem unlikely given the UK government’s current red lines, it seems that passporting rights will require some form of approximation of legislation.

In other words, these exceptions mean that the MFN principle must not be a barrier to a future EU-UK trade deal including financial services.

Even if no such reservations existed, it remains to be seen whether the EU’s trading partners would find it practical to challenge larger benefits under a future EU-UK deal. On the one hand, it is probable that they would seek to secure passporting rights under their FTAs with the EU if such were given to the UK.

On the other hand, UK’s passporting rights allow non-EU firms properly established in the UK to get automatic access to sell financial services across the EU. Non-EU firms, including Canadian ones, have been using this route extensively. Whether the EU will agree to continue this scheme post-Brexit is yet to be seen.